Short selling and meme stocks - The GameStop and Archegos sagas, what they mean for regulation and the latest research on short selling bans ...
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Short selling and meme
stocks
The GameStop and Archegos sagas, what
they mean for regulation and the latest
research on short selling bans.
7
What is short selling? Short selling works on the premise that a
stock is currently overpriced and is likely
Short selling is a trading tactic used by to fall in value at some point in the near
investors to profit from stocks that are future. Of course, there is always the risk
likely to decline in value: that the stock may increase in price,
meaning the investor will have to buy
● An investor borrows some stocks them back at a loss (because the stocks
from a brokerage and are only borrowed from the brokerage
immediately sells them on. and must be returned.)
● The value of the stock decreases
(they hope). What is a meme stock?
● The investor buys the stock back
at the current, cheaper, market A “meme stock” is a stock which has gone
value. viral online, i.e. it has been widely
● They then return the stocks to discussed via social media platforms and
the brokerage, keeping the online forums, drawing attention from
difference in price (their profits.) retail investors.
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him money though, because Archegos was
Why should we care about short so lucrative for them.
selling and the meme stock
phenomenon? Archegos ran into trouble when it became
over-reliant on leverage (i.e. borrowed
assets) to chase higher returns in the
GameStop
market. Its lenders began to get nervous
because Hwang was losing too much
One example of a so-called meme stock
money through his leveraged investments,
and the risks of short selling in action is
so they issued a margin call. The total
the recent GameStop price hike. A meme
losses are estimated to be around
stock is a stock which has seen a
US$20bn.
considerable increase in volume, not due
to how the company has been performing,
Multiple lenders issued margin calls with
but due to it receiving lots of publicity
Archegos simultaneously, which is what
online. Meme stocks often quickly become
triggered its collapse.
overvalued, drastically increasing in price
over a short period.
How did Archegos’ collapse affect
others in the wider market?
GameStop began receiving increased
attention from retail investors after it was
Credit Suisse Group AG, one of Hwang’s
revealed on a Reddit forum that hedge
biggest lenders, lost US$4.7bn and
funds were shorting the stock. It began as
Nomura Holdings lost approximately
an opportunity for retail investors to profit
US$2.bn due to the collapse of Archegos.
by shorting the stock too, but soon
Morgan Stanley is understood to have lost
escalated into an online campaign to beat
around US$911m. Hwang’s family office
large, multi-billion dollar hedge funds at
held tens of billions of dollars in stocks
their own game by hiking the GameStop
and so margin-call selling drove stock
share prices higher and higher, so that
prices lower and lower creating a
they were forced to sell at a loss.
downward spiral of low prices, big losses
and more margin calls.
Archegos Capital Management
Shares of Archegos, ViacomCBSm,
Discovery Communications and others
Archegos Capital Management (Archegos)
(the media stocks Archegos had
was a family-run investment office owned
leveraged) temporarily crashed during the
by Bill Hwang. Hwang had been a
unwinding process.
successful trader for many years until he
was accused of insider trading by the US
Risk management lessons from
authorities and pleaded guilty to wire
Archegos
fraud in 2012 on behalf of his hedge fund,
Tiger Asia. Major banks including Credit
One of the key issues in the case of
Suisse and Nomura were still keen to lend
Archegos was that because it was
registered as a family office, it wasn’t
subject to the same reporting
requirements as a hedge fund and
therefore did not need to publicly disclose
Archegos was registered as a family its position on a quarterly basis. As a
result, none of its lenders were aware
office, so it wasn’t subject to the same
Hwang was using credit from up to eight
reporting requirements as a hedge different banks to invest in just a handful
fund of stocks.
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Brokerages should be prepared for scrutiny
around the nature of trading apps
What does all this mean for
regulation and compliance? Brokerages should also be prepared for
scrutiny around the nature of trading
Most of the potential regulatory apps, with concerns being raised about
developments in this area appear to be the gamification of trading and the ease
aimed at US markets (probably because with which trades can be placed.
the US is one of the most liberal countries
in its approach to short selling regulation), Shorter settlement cycles
so financial institutions should expect to
face scrutiny from the US House Financial All market makers - including banks -
Services and the US Senate Banking should expect the settlement cycle to be
Committee. shortened as part of these regulatory
developments. Currently, it takes two days
Regulatory analysis provided by law firm once a trade has been placed for those
Hogan Lovells via Lexology.com suggests stocks to be transferred to the new
hedge funds are likely to be required to owner/borrower. Shortening this cycle
make additional disclosures in relation to would help to reduce the credit risk
their short-selling positions. There will also generated during that period. Retail
probably be expanded scope in this area traders might also see limitations put on
on the 13F disclosure form that how many trades they can make on a
investment management firms are certain stock in a certain time period.
required to submit to the SEC (listing all
assets currently under their management.) There is also likely to be some legal fallout
from the Archegos scandal as further
details from the investigation emerge.
“Firms should consider the risk of being
called to testify before a hostile
congressional panel,” say lawyers at
Hogan Lovells. “Before the letter from
Congress comes in, thinking about who
should testify and preparing that person
to provide written and oral testimony to
Congress, will be critical.”
US regulation for short selling
Several hearings have been held by the
House Financial Services Committee and
the Senate Banking Committee to discuss
the Gamestop and Archegos events and
the potential regulatory response. Areas
under discussion include:
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● 13F disclosures the Bank of England, Andrew Bailey
● family office exemptions warned against the trading method,
● gamification of trading apps saying in an interview with the BBC:
● options trading for retail traders “Anybody who says, ‘I can make a load of
● payment for order flow money by shorting’ which might not be
● trading ahead. frankly in the interest of the economy, the
interest of the people, just stop doing
The SEC is reviewing its rules around what you’re doing.”
short-selling, securities lending (which
underpins the short selling market) and Which countries banned short selling in
the nature of retail brokerage platforms. It 2020?
will also look at reporting rules for total
return equity swaps, which helped fuel the EU regulations state that financial
collapse of Archegos. The regulator is due regulators can suspend short selling when
to publish its draft rules and requests for the price of one or more securities falls by
comment on the areas listed above, soon. a set percentage. In 2020, Italy, Spain,
Belgium, France, Greece and Austria all
Should short selling be banned? imposed temporary short selling bans on
certain shares.
The past 12-18 months have brought
short selling and its impacts on the wider Thailand and the US chose a different tack,
markets into focus. During times of making short selling more expensive for
economic stress, some jurisdictions traders, rather than imposing a blanket
choose to place a temporary ban on short ban.
selling to try to prevent a market crash.
Research on short selling bans
Between 23rd and 28th February 2020, as
the extent of the COVID-19 pandemic Evidence around the benefits of banning
began to unfold, US$6tn was wiped from short selling during a crisis is mixed. There
global markets, with sell-offs exceeding is considerable research into the potential
those seen during the financial crisis of pros and cons of short selling bans, much
2008. of which is summarised in NERA
Consulting’s white paper, Short Selling: To
Short sellers can earn huge profits when Ban or Not to Ban?, which was published
share prices drop rapidly, but this can be pre-Archegos/GameStop, but post COVID-
damaging to the wider market, triggering 19. “The efficacy of historical short-selling
panic selling. In March 2020, Governor of bans in stemming market declines
has...been called into question,” says the
report. “For example, Battalio et. al. (2012)
examined the US’s 2008 short-selling bans
and found that they had little impact on
stock prices. Similarly, Beber and Pagano
(2013) examined data for approximately
17,000 stocks in 30 countries over the
2008–2009 period and concluded that
US$6tn was wiped from global short-selling bans were ‘at best neutral’ in
terms of
markets, with sell-offs exceeding
those seen during the financial crisis
7
short sellers are considered to be the investigative
journalists of the capital markets
their effects on stock prices.” regulators and at what point this is most
effective for preventing a market crash.
Xi Jiang, an assistant professor of
accounting at Duke University’s Fuqua Distinguishing between informed and
School of Business in Hong Kong has been uninformed short selling
researching the impact of short selling
bans. In March 2021 he co-published a Jiang explains that it is important to make
model and analysis on the topic: a distinction between informed short
Manipulation, Panic Runs and the Short selling, i.e. trades made by an investor
Selling Ban. Jiang says critics of a ban who has good reason to believe a stock is
argue that “short sellers are considered to overpriced and will soon drop in value;
be the investigative journalists of the and uninformed short selling, i.e., panic
capital markets…They are exposing failing and rumour-induced sell offs. Informed
business models, bad management and short selling provides important insight on
excessive leverage...On the other hand, the market and can actually impact a
there are proponents of the short selling company’s decision to go ahead with a
ban saying [it] is necessary, because short major deal or merger. But telling the
sellers generate rumours, create fear and difference between these two scenarios
panic and [it] brings down good firms.” isn’t always straightforward.
In the study, Jiang argues that both sides The feedback effect
have merit and can be incorporated into
his model which provides an indication of Jiang gives the example of Coca-Cola’s
when a ban should be considered by plan to buy Quaker Oats in 2000. The
stock market reacted negatively to the
announcement of the acquisition; the
price of Coca-Cola stocks declined
because people were selling, so Coca-Cola
pulled out of the deal. This is known as the
“feedback effect.” Coca-Cola evidently
believed there was a legitimate reason
why the market felt the deal was a bad
idea and trusted its feedback. In this type
of scenario, a blanket ban on short selling
would be bad for the markets. But, argues
Jiang, if the feedback effect is combined
with another factor known as the
“coordination effect,” a different approach
may be beneficial.
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The coordination effect about how trading restrictions will operate
during periods of stress and volatility.”
An example of the coordination effect in
action is a bank run. If everyone is taking The SEC didn’t deem it necessary to put a
their money out of a bank because they blanket ban on short selling during market
are worried it may collapse, this then volatility triggered by the COVID-19
causes panic and increases the likelihood pandemic. Thanks to lessons learned from
of bank collapse anyway. If there is the 2008 financial crisis, it was felt enough
potential for the coordination effect to liquidity could be provided by the Federal
come into play during a short-selling Reserve to prevent a run on the banks.
event, uninformed speculators can profit
from short selling. “In this case, we show What are the alternatives to banning
that a blanket ban on short selling is short selling?
beneficial,” says Jiang.
One way regulators choose to minimise
In other words, short selling bans are most short selling in a crisis is to make it more
effective when the coordination effect is expensive. The thinking behind this is that
strong and the probability of informed most uninformed short selling tends to
trading is low and uncertainty is high, such happen via retail investors, who make less
as during the global financial crisis and the money than larger, more-informed
COVID-19 pandemic. investors such as hedge funds. Making it
more expensive therefore tends to
The SEC on short selling discourage uninformed short sellers more
than informed ones. However, this does
The US Securities and Exchange require the ability to determine how much
Commission has said it supports a ban on profit short sellers are likely to make in
short selling in the event of a crisis. It order to ensure the cost of selling is
temporarily banned short sales of most greater than the profits of retail investors
stocks in 2008. Former SEC chair Jay and less than the profits of hedge funds.
Clayton said in March 2020 that “we This also has ethical connotations, because
shouldn’t ban short selling,” and instead it means the system works in favour of
pointed to the alternative uptick rule larger investors and against smaller retail
which was implemented in 2010. investors.
What is the alternative uptick rule? Risk management lessons from
GameStop
The alternative uptick rule was put in place
to allow investors to exit any long The ramifications of the GameStop
positions before short selling happens due incident are still unfolding as Robinhood,
to a fall in share prices. The rule is the brokerage app used by retail investors
triggered when a share price falls by at to buy and sell GameStop shares, faces
least 10% in one day. “The rule is designed class action litigation and a US$70m fine
to preserve investor confidence and from US regulators.
promote market efficiency, recognising
short selling can potentially have both a What did Robinhood do wrong?
beneficial and a harmful impact on the
market," said then-SEC chair Mary Robinhood was forced to limit sales of
Schapiro in 2010. “It is important for the GameStop shares because it could not
Commission and the markets to have in meet capital requirements from the NSCC
place a measure that creates certainty (National Securities Clearing Corporation)
as the share price shot up. The NSCC
reportedly contacted Robinhood in the
middle of the night asking for more than
US$3bn, forcing the brokerage to restrict
sales of GameStop.
7Jim Swartwout, chief operating officer of “Any one of them can’t really influence the
Robinhood Securities said he was woken price. But you put them all together, and
on 28th January 2021 at 5.55am New York they can have substantial influence… [they
time by the firm’s treasury manager who have] the power of a large institutional
informed him of the clearing house’s investor.”
requirements. “We had expected to have a
higher than usual requirement,” said
Stalwart, “but what we received from the
system-generated NSCC invoice was a
US$1.4bn value-at-risk calculation -
tenfold our normal. But on top of that they
had added a US$2.2bn special
maintenance call. Our total was around
US$3.7bn.”
Robinhood restricted trading of GameStop
shares that same day in order to allow
time to raise the necessary capital.
Questions have been raised around why
the firm was so underprepared for the call.
Campbell Harvey, a professor of
international business at the Duke Fuqua
School of Business says it was a basic risk
management failure. “The surprise to me is
that Robinhood wasn't doing these
calculations in real time...The formula [for
calculating capital requirements] is not
secret. I think like any basic risk
management process, they need to be
figuring out what the capital requirement
actually is. They were blindsided and it
doesn't make any sense to me.”
The future of short selling
It doesn’t look as though short selling as a
trading tactic is going anywhere soon, but
recent events have forced regulators to
focus on this area and have brought into
focus how well the traditional financial
markets function in the modern world.
Harvey argues that the inefficiencies and
inequity exposed by the GameStop saga in
particular are pointing towards a more
decentralised, peer-to-peer based financial
system where transactions are instant.
“The tide is going out and the power of
the retail investor should not be
underestimated,” says Harvey. “We have
seen they can exercise substantial
influence over prices.”
7Further reading
The basics of shorting stock, thebalance.com
What is a meme stock? thebalance.com
Preparing for the regulatory response to meme stock investing, Lexology.com
Short selling: to ban or not to ban? Nera Economic Consulting
Manipulation, Panic Runs and the Short Selling Ban, Xu Jiung et al
Short Selling, ESMA (European Securities and Markets Authority)
Bill Hwang had US$20m then lost it in two days, Bloomberg.com
US SEC chair says reviewing short-selling, swap rules after GameStop, Archegos Sagas,
Reuters.com
Short-selling bans and bank stability, ESRB (European Systemic Risk Board)
7About Risk Universe
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